Capital Gains and the Tax Rate
In my prior post I pointed out how inflation can increase the tax burden by pushing tax payers into higher brackets as a result of inflation, rather than a real increase in wages. This means you’re paying higher taxes, yet earning less. Unfortunately, it doesn’t stop there! It gets worse when we talk about capital gains taxes. With inflation, you can end up losing money, despite what appears to be a positive return. Here’s how.
The long-term capital gains rate is currently 15%, meaning that if, for example, you invest $1,000 and after a year sell it for $1,100, you will have to pay $15 in capital gains tax.
(1,100 – 1,000) /1,000 = 10% Pre-tax gain on your investment
(1,100 – 1,000) = 100 * 15% = 15 (Taxes) à (1,100 – 1,000 – 15)/1,000 = 8.5% After-tax gain on your investment
Unlike income tax, capital gains does not take into account inflation under CPI or any other measure. So now let’s throw inflation into the equation using the example from above.
If inflation is running at an annual rate of 9%, your inflation adjusted return can be calculated as follows:
10% return on your investment – 9% inflation = 1% real return on your investment.
But you still have to pay taxes on the 10% nominal return.
8.5% after tax return on your investment – 9% inflation = -0.5% return (an actual loss on your investment).
Now if that didn’t drive you batty, it is actually possible to pay taxes on an after-inflation LOSS from your investment.
Let’s say you again invest $1,000 in year one and receive the following annual returns.
| Beginning Balance | Annual Return | Value at end of year | |
| Year 1 | 1,000.00 | 4% | 1,040.00 |
| Year 2 | 1,040.00 | 5% | 1,092.00 |
| Year 3 | 1,092.00 | 3% | 1,124.76 |
| Year 4 | 1,124.76 | 6% | 1,192.25 |
This means that you will pay ($1,192.25 – $1,000) * 15% = $28.84 in taxes for a total pre-inflation, after tax return of (1,192-1,000-28.84)/1,000 = 16.34% / 4 = 4.09% annual return.
Now let’s add inflation of 5% a year to this, and keep the returns in terms of year 1 dollars.
| Beginning Balance | Annual Return | Inflation | Real Rate of Return | Value at end of year | |
| Year 1 | 1,000.00 | 4% | 5% | -1% | 990.00 |
| Year 2 | 990.00 | 5% | 5% | 0% | 990.00 |
| Year 3 | 990.00 | 3% | 5% | -2% | 970.20 |
| Year 4 | 970.20 | 6% | 5% | 1% | 979.90 |
This means that after inflation you have a pre-tax loss of (979.90 -1,000)/1,000 = -2%
But you still have to pay $28.84 in taxes despite the loss, so the after-tax loss is
(979.90-1,000 – 28.84)/1,000 = -4.9%
We believe that high rates of inflation are a very real possibility so we are positioning our portfolios to hold assets that do well under such an environment. We are very aware however, that given the “wet blanket” theory I mentioned in an earlier post, inflationary pressures may be overwhelmed by the significant debt load facing our nation, resulting in unusually low rates of inflation. In this case, we can be relatively confident that interest rates will rise, thus we’ve positioned portfolios such that they will do well under either an inflationary environment or under high interest rates. One obvious choice here has been to keep the duration of our bonds low.
